During last month’s US equity market meltdown we proposed that tax loss selling was responsible for an outsized part of the rout. Here was our argument:
- In October/November 2018 investors sold down Technology stocks, generating very large short and long term capital gains.
- Up until December 13th, the S&P 500 had managed to hold onto flat/slightly positive YTD total returns.
- When it started to break down on December 14th, investors shifted gears and started to sell losing positions to minimize the taxable effect of their Tech stock sales in what was shaping up to be a down year for the S&P.
- That tax loss selling could not have come at a worse time, with illiquid year-end markets unable to soak up the incremental supply. Peak selling occurred on December 24th.
As simple as this explanation is, this month’s strong rally fits neatly into the framework. Yes, Fed Chair Powell’s turnaround on rate policy has been a powerful tailwind. But cleaning up all those tax loss sales has certainly helped.
Three further points on this topic:
#1. Last year’s worst-performing S&P 500 stocks are doing very well so far in 2019.
- In December we highlighted the 11 worst performing stocks in the S&P 500. They were: General Electric (GE), Mohawk (MHK), Newfield Exploration (NFX), Affiliated Managers (AMG), Invesco (IVZ), Western Digital (WDC), L Brands (LB), Alcoa (AA), Unum (UNM), Brighthouse Financial (BHF), and IPG Photonics (IPGP).
- From the first time we highlighted these stocks (evening December 17th) to the end of 2018, they underperformed the S&P 500 by an average of 156 basis points. This shows that continued selling all the way into year-end especially hurt their performance.
- Conversely, these 11 stocks have dramatically outperformed so far in 2019. Their average return YTD is +9.5% versus a 3.6% gain for the S&P 500. Almost half of these 2018 losers are up double digits: GE (+18.1%), NFX (+19.7%), UNM (+10.2%), BHF (+10.1%), and IPGP (+12.9%).
- Only one stock on the “Worst 11 names of 2018” list has underperformed the S&P 500: L Brands, thanks to an earnings warning, is only +3.1% higher on the year.
- Note: while our highlight list of tax loss sellers may have more room to run, their YTD gains is all one can rationally expect from the strategy of buying big losers at year-end.
#2: US Small Cap stocks have shown better returns in 2019 than Large Caps, which makes sense in the context of last year’s underperformance for this asset class.
- Recall that the Russell 2000 was down 11.0% last year on a total return basis versus the S&P 500’s -4.2% return.
- For the YTD 2019, the Russell 2000 is up twice as much as the S&P 500 (a 7.3% gain versus a 3.6% advance).
- Also keep in mind that the “January effect” equity market anomaly is most typically associated with small cap stocks, so this outperformance makes sense from that perspective as well.
#3: Our message from this analysis is to treat the early 2019 rally for US stocks with some caution.
- As much as the Fed’s recent volte-face is a welcomed change, it is not the only reason US equities have found their footing in the New Year. Turning the calendar helped a lot as well, and may well have given stocks more of a boost than Chair Powell’s comments would have otherwise merited.
- Fed Funds Futures are now somewhat more inclined to believe the Fed will raise rates some time in 1H 2019 and a cut is off the table. The odds of a 25 bp increase by the June meeting stand at 21%, up from just 5% a week ago.
- As we highlighted last week in the Market’s section, Q4 financial reporting season (starting this week) should see analysts continue to reduce their expectations for 2019 earnings. As it stands today, the Street is only looking for +1.8% earnings growth for Q1 2019 and 6.9% for the year as a whole.
- The next obvious catalyst for US/China trade negotiations is the upcoming Davos World Economic Forum meeting. That doesn’t kick off until January 22nd, and President Trump has already said he will not attend.
Bottom line: the easiest money of 2019 has likely been made, thanks in large part to a clean up of last year’s tax loss selling. If the S&P 500 closed the year right where it is today, the total return would be 5.6% (3.6 points of capital gain, 2.0 points from dividends). This would be in line with the 20-year average, a good enough result.